Fiscal Policy: The Keynesian View and Historical Perspective. 3. 11. 3. 11. The Great Depression and Macroeconomics. The Great Depression exerted a huge impact on macroeconomics. The national income accounts that we use to measure GDP were developed during this era.

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For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4).

Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until …

The multiplier concept also works in reverse – reductions in spending will also be magnified and generate even larger reductions in income.

Even a minor disturbance may be amplified into a major disruption because of the multiplier.

Keynesians argue that the multiplier concept indicates that market economies have a tendency to fluctuate back and forth between excessive demand that generates an economic boom and deficient demand that leads to recession.

1. What is the multiplier principle? Does the multiplier principle make it more or less difficult to stabilize the economy? Explain.

2. Why did John Maynard Keynes think the high level of unemployment persisted during the Great Depression? What did he think needed to be done to avoid the destructive impact of circumstances like those of the 1930s?

Automatic Stabilizers: Without any new legislative action, these tools will increase the budget deficit (reduce the surplus) during a recession and increase the surplus (reduce the deficit) during an economic boom.

The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action.

1. Why is the proper timing of changes in fiscal policy so important? Why is it difficult to achieve?

2. Automatic stabilizers are government programs that tend to:a. bring expenditures and revenues automatically into balance without legislative action.b. shift the budget toward a deficit when the economy slows but shift it towards a surplus during an expansion.c. increase tax collections automatically during a recession.

In the Keynesian system, when total output is less than planned aggregate expenditures, purchases exceed output and inventories decline. Firms expand their output to rebuild their inventories to regular levels.

When output is more than planned aggregate expenditures, output exceeds purchases, and inventories rise. Firms reduce output in order to reduce excessive inventories.

When planned aggregate expenditures equal total output, there is Keynesian macroeconomic equilibrium.

Once full employment is reached, further increases in AE, such as to AE3, lead only to higher prices – nominal output expands along the black segment of AE (those points beyond the full employment output level at $14.3 trillion) but real output does not.